Cliff Fix Hits Small Business

Many Small Entities or Firms May Face Higher Taxes This Year After the Deal

By

Emily Maltby and

Angus Loten

Updated Jan. 3, 2013 10:29 a.m. ET

It's likely to be a year of painful decision-making for small-business owners like Tom Secor of Norwalk, Ohio, one of hundreds of thousands of Americans who could face a higher tax bill after Washington's last-minute deal to avoid the fiscal cliff.

Mr. Secor co-owns Durable Corp., a 90-year-old maker of rubber mats and loading-dock bumpers with 36 employees and just under $10 million in revenue last year. Because the company is structured as an S-Corp, or partnership, the 55-year-old Mr. Secor and his four partners each pay taxes on their share of the profits at their personal income-tax rate. In Mr. Secor's case, that rate was 35% last year.

But this year, the company's profits are likely to boost Mr. Secor's personal income above $400,000. And, as a result of the fiscal-cliff compromise struck Tuesday, that means his tax rate on the income over that amount would jump to 39.6%.

The fiscal-cliff deal didn't change the corporate tax rate, which is no more than 35%. But converting the company to a corporation isn't an option, Mr. Secor says, because he and his partners would end up paying taxes twice, at the corporate and individual levels. Tax experts say it is also difficult to switch back once a business has become a C-Corp, and some believe it's easier to sell a business that is an S-Corp.

The five co-owners also can't reduce staff because the plant is already operating with the minimum number of employees it needs after nine workers were laid off two years ago and five more who have left since weren't replaced. Nor can they move their business to the Cayman Islands or some other tax haven, because the legal fees to do so would be too steep.

WSJ/Vistage Small Business CEO Survey

In addition to higher taxes, small-business owners must contend with planning for provisions in the health-care law that take effect this year and could significantly increase their costs if they have 50 or more full-time-equivalent employees. Some of them have already responded by turning to part-time and contract workers.

Meanwhile, owners may find it easier to access capital thanks to the Jumpstart Our Business Startups, or JOBS, Act passed last year, which allows them to sell equity to pools of investors online. It's still not clear, though, what regulations will govern this practice because the key rules for the law haven't been set.

About a third of small companies rank economic uncertainty as the single biggest obstacle to long-term growth in the year ahead, according to a survey fielded from Dec. 10 to 19 by The Wall Street Journal and Visage International, a peer-advisory group. The heads of 926 small firms in a range of industries, all of them with less than $20 million in annual revenue, completed the online survey.

Here's a glimpse at a variety of challenges in store for small businesses in 2013.

Some Face Tax Rise

Many business owners who claim business profits on their personal income taxes are likely to be affected by the higher tax rates. The compromise called for taxes to rise to 39.6% from 35% on personal income above $400,000. In a 2011 study, the Treasury Department found that raising taxes on incomes over $500,000 would affect roughly 750,000 small businesses organized as S-Corps, partnerships and other small entities.

More

Due to anticipated tax increases and spending cuts sparked by the fiscal-cliff talks, about 29% of the chiefs of small firms planned to hire fewer workers, according to Vistage polling in December. An additional 32% expected lower investment spending, or fewer purchases of vehicles, property and equipment. Some business owners may explore strategies for lowering taxable income, such as maximizing their contributions to their retirement funds and matching employees' contributions to 401(k) plans.

Mr. Secor says any added tax bill, which would be paid out of cash flow, would prevent him from offering employees raises and profit-sharing. But due to weak sales, the firm has given its staff only small raises—about 3% across the board—just twice since 2008. "All we've done over the past three years is circle the wagons," he says.

Health-Care Challenge

Small-business owners now have just 12 months to prepare for new rules under the 2010 health-care overhaul law. The law requires employers with 50 or more full-time equivalent workers to offer health insurance by 2014 or potentially pay a penalty.

Dealing with higher labor costs is a big concern, according to Gary Levy, a partner at CohnReznick LLP, a national accounting, tax and advisory firm in New York that expects the new law to drive up labor costs for small employers. One question on the minds of small-business owners with 50 or more employees, for instance, is whether independent contractors will be counted in the tally of employees. Owners are also waiting for guidance on the types of plans they need to offer to meet the law's minimum requirements. "I see frustration and confusion," Mr. Levy says.

Only 14% of the business owners said they had a clear understanding of the health-care law, according to The Wall Street Journal /Vistage Small Business CEO survey in December.

Nearly 40% of small-business owners cited the health-care law as an obstacle to hiring, while just 8% cited Social Security, Medicare or workers' compensation, the survey found.

To rein in costs, Randy Nelson says he's considered freezing hiring and expansion plans at VFS Fire & Security Inc., his Anaheim, Calif., company, which installs and maintains fire-sprinkler and alarm systems. Only about half of Mr. Nelson's 60 employees now opt in to the firm's health-care plan, he says. Though VFS covers just half of the cost of premiums, Mr. Nelson says that last year the plan cost roughly $120,000, an expense that is likely to at least double when the remaining employees opt into the plan next year.

Easier Financing

Banks appear to be loosening the purse strings for small companies as rising sales enable more borrowers to take on debt. The number of outstanding commercial and industrial loans under $1 million has inched up since 2011, according to data from the Federal Deposit Insurance Corp.

Lenders typically look at three years of a business's financial records before making lending decisions, so this year, when they will be reviewing businesses' 2012 statements, they are likely to find an improvement, reflecting the pickup in the economy and consumer spending since 2011.

Still, there are plenty of owners waiting on the sidelines, including Dave Prizio. The president of Prizio Construction Inc. in Costa Mesa, Calif., tried twice in the past two years to get a $500,000 credit line but was told he would have to pledge $500,000 in cash collateral against it. He says the company needs the capital to finance larger construction projects. The credit crunch, he adds, "has cost us at least one pretty-good-sized project about 18 months ago" because he couldn't get a loan.

More business owners appear to be turning to alternative forms of borrowing such as asset-based lending. These options are expected to get cheaper as demand grows and the market broadens.

The JOBS Act, approved by Congress last April, is also poised to ease decades-old financing restrictions on startups and small firms, in part by allowing entrepreneurs to sell equity stakes to pools of online investors on so-called equity crowdfunding websites. The Securities and Exchange Commission missed a year-end deadline to set specific regulations for the new law, such as disclosure and reporting terms.

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